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HMRC internal manual

International Manual

HM Revenue & Customs
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Interest imputation: dealing with ‘equity function’ arguments: Working a case

Error or mistake and overpayment relief claims

A number of equity function arguments have been mounted on the back of claims to error or mistake relief, particularly where there is a strong retrospective element.

For claims made on or after 1st April 2010, error or mistake relief is replaced by overpayment relief, inserted (by FA09/S100) as TMA70/SCH1AB, but the same principles apply. From this date claims cannot be made for error or mistake relief.

A claim to overpayment relief may be made where a person has paid an amount of income tax or capital gains tax which they believe was not due, and the legislation includes a series of “Cases” where the Commissioners are not required to give effect to a claim. This includes Case G, where

(a) the amount paid, or liable to be paid, is excessive by reason of a mistake in calculating the claimant’s liability to income tax or capital gains tax (other than a mistake in a PAYE assessment or PAYE calculation), and

(b) liability was calculated in accordance with the practice generally prevailing at the time.

The Self-Assessment Claims Manual elaborates on the meaning of practice generally prevailing at SACM12105. It is difficult to see how a claim may successfully be made under this legislation in relation to an equity function case. The claim would have to identify a “mistake” in circumstances where all that has happened is that what actually took place is reinterpreted in the light of later events or changed circumstances, and the company now wishes to roll that reinterpretation back to the earlier period. The words from Schedule 1AB in the paragraph above would seem to preclude that.

Practical considerations

In all cases these transactions, which have apparently become ambiguous or changed their natures, started life ostensibly as loans. The relationship established by the transaction was that of lender and borrower, not parent and subsidiary, or equity investor and investment, and OECD principles require that the primary task is to price the provision that actually exists between the parties, in this case a loan, and to make any necessary adjustments to the actual terms and conditions until they equate to those which would be found at arm’s length.

Starting from the premise that the transaction is a loan, what would a third party lender do if the company could not pay its interest? Responses might include:

  • intervention in a way that would protect the lender’s interests (exercising security by seizing saleable assets, say) but which might jeopardise the interests of the borrower
  • the lender granting a period of grace, to allow the borrower to recover, postponing (ultimately at a cost to the borrower, in terms of compounding of interest or agreement of a higher rate to compensate for interest being allowed to accrue), rather than losing the lender’s return.
  • some rearrangement of the borrower’s priorities in order to meet the loan obligations.
  • Genuinely converting some part of the debt into equity, thereby strengthening the borrower’s balance sheet and perhaps enabling it to retain part of the borrowings or obtain replacement borrowing elsewhere.

A highly unlikely option would be for a third party lender to make a capital contribution, effectively a free gift to help bale out the borrower, which would give the donor no greater ongoing stake in the business. At arm’s length, lenders do not forgive loans as they make them.

An equity function argument is not all-or-nothing, as seems often to have been assumed in the past. It is possible to agree that part of the transaction constitutes a loan on which interest should be imputed while part performs an equity function, but as a temporary fix for an unexpected situation.

Imputing interest

Once it is agreed that interest will be imputed on some part of the loan, it will be necessary to agree how much interest will be brought into account (see INTM502050). It should also be agreed that the UK company should self assess for future years taking into account the imputation of interest by reference to the arm’s length standard and in accordance with any understanding with HMRC.

Depending on the terms of the double taxation agreement between the countries of the lender and recipient, the overseas company may be able to obtain an adjustment under the Mutual Agreement procedure, allowing it a deduction reflecting the imputed income taxed on the lender.

Interest rate

It is necessary to agree an interest rate for imputed interest on an outward loan. The rate will be determined by the various factors set out at INTM516030, including currency risk, amount and duration, purpose and credit risk.

In the absence of detailed terms, it should be sufficient to settle on an appropriate LIBOR or EURIBOR rate with a suitable margin. The rate should reflect the duration and renewal terms of the loan.

It is reasonable to take note of the lender’s own borrowing costs, since it would seem uncommercial to on-lend at a loss, unless there is some greater commercial prize in prospect. If the lender is not making a sufficient ‘turn’ to cover their own finance costs, the sensible response might be to terminate the debt, not to leave it on loan to a group company for a poor return. In setting the imputed interest rate, it may make sense to start with the cost to the lender of providing the funds (costs of borrowing, administrative costs, etc) and add a margin or “turn”. This approach is relatively simplistic, and it may be necessary to take into account the history and terms of the lender’s own debt commitments.

Once agreement has been reached in principle on the imputation of interest, the company should prepare and submit the interest calculation as part of the revised computations.

The ‘can’t pay’ argument

See INTM501040.

Other arguments

  • Third party analogies - i.e. what would a third party lender do in the circumstances? Defer calling the borrower to account? If so, for how long? Restructure the debt?
  • Role arguments - what is the role of the lender within the group? Is it some kind of treasury or finance company for the group? If not, why is it lending? Does it make sense?
  • Relationship arguments - is the borrower a direct or indirect subsidiary of the lender? If not, why is the lender supporting the borrower, and how can equity arguments be relevant? Is there a management or business stream connection between lender and borrower? Should the borrower properly have looked elsewhere for financial support? Should it do so now?
  • Other purpose - is there a tax cost outside the UK, associated with lending, which could be avoided by reclassification as equity? HMRC does not accept that administrative or tax savings are valid reasons to reclassify debt as equity.
  • Anti-equity arguments - if the borrower is a subsidiary of the lender, or even within the same group, an additional holding of equity by the lender will not necessarily give it greater rights to dividends. The lender may be giving up an immediate or more certain income stream in exchange for the uncertain hope that extra capital may create extra profits.
  • Equity injection argument - if the lender (or parent) converts part of the debt to equity, or put new equity into the borrower, the latter will then be in funds to meet its obligations. It may not be solely the responsibility of the lender to bolster up the borrower - what about other group companies?

The idea is to consider the problem from a number of angles and find an appropriate solution. Whichever way this is approached, it starts with a lender who has apparently changed their mind about the character of a loan.